Munis, Notes, Maturity: A Bond Primer

Investing in bonds is as complicated as investing in stocks. There are many types from which to choose. You can invest in government, municipal or corporate bonds. Or you can buy into mortgage and asset-backed securities, zero-coupon, U.S. Treasury Inflation-Protected Securities or international bonds. Each bond will have different credit ratings, yields, maturities and other features. Each carries its own risks. We try to boil it down for you.

· What are bonds?

Put simply, they are IOUs. You're lending money to the U.S. government, a state or local government, a foreign government, a corporation -- any institution that sells bonds. In exchange, the issuer will pay you back the principal when the loan matures, or expires, plus whatever interest was agreed on. Bonds attract investors because they typically offer a steady stream of interest income plus repayment of the principal. Because they can be a vehicle for preserving capital, financial advisers often suggest that any portfolio contain a mix of stocks and bonds or other forms of fixed income.

· What should you consider when shopping for bonds?

No two bonds are alike. They come with a number of features that, depending on your time horizon and risk tolerance, may not be right for you. Here are some to think about:

1) Interest rates: They can either be fixed, variable or payable when the loan expires. Most are fixed. Variable rates change along with such indexes as the London interbank offered rate, or Libor. You can receive payments semi-annually or when the loan is repaid.

2) Maturity: A bond reaches maturity when you are repaid the principal of the loan. That can happen within days or years. Typically, bonds are divided into short-term notes (up to five years), intermediate notes (5 to 12 years) and long-term notes (12 to 30 years, sometimes even longer.)

3) Yield: This is the actual return you get based on the price you paid and the interest payments. You can look at the current yield, which is the annual return on what you paid for the bond. But a better judge of the worthiness of the bond is to calculate the yield to maturity, which determines your return if you hold onto the bond until it expires. Remember, the higher the yield, the greater the return but the greater the risk as well.

4) Redemptions: Sometimes, despite their stated maturities at the time you buy the bonds, these loans can terminate early or last longer than expected. Some bonds have "call provisions" that require the issuer to repay the principal before it matures. This typically happens when the interest rate drops. On the flip side, some bonds have "puts," which let the investor ask the issuer to buy back the bond before it matures. This usually happens when the investor needs cash or when interest rates have risen to a point where he or she can turn a profit.

5) Credit quality: This is a way to calculate risk. The safest bet would be U.S. Treasury bonds, backed by the "full faith and credit" of the U.S. government. The riskiest would be below-investment grade, high-yield "junk" bonds. In the United States, the credit quality of governments and companies is monitored by the ratings agencies: Standard & Poor's, Moody's and Fitch Ratings. Lower-quality companies or governments will sell bonds with higher interest rates. So remember, the higher the interest rate and the lower the quality, the riskier the investment but the greater the opportunity for reward.

6) Taxes: You don't have to pay state or local income tax on the interest from U.S. Treasurys. That is often the case with municipal bonds as well. There is no federal income tax on most munis. Why would someone turn down a tax-exempt investment, you might ask? It all depends on your tax bracket. You should seek help from an adviser to determine whether you could actually earn more from a taxable bond.

7) Price: This fluctuates with market conditions, credit quality, and interest rates especially. The rule of thumb is this: When prices fall, the yield rises.